What Happened With the Panic of 1907?
The widespread bank panic of 1907 was the first of many worldwide financial crises’ experienced in the twentieth century. Not only did it transform a recession into a contraction, but it lead to a monetary reform movement. The establishment of the Federal Reserve System fundamentally changed how the banking system works in America. At its core, the impact of the Panic of 1907 is still felt today. Before we get started, let’s do a quick review of what a bank run is.
What Is a Bank Run?
A bank run happens with many people, or financial institutions all try to withdraw their money at once. In many cases, this is due to a lack of faith in the bank and its solvency.
People start to panic, and all rush to get their money. Understandably, as more and more people withdraw their funds, the bank’s reserves may not be sufficient to cover the withdrawals.
What was the bank panic of 1907? At the turn of the 20th century, the U.S. experienced a short-lived banking and financial crisis.
At its core, it was caused by laissez-faire access to capital thanks to easy money policies implemented by the U.S. Treasury. With access to easy money, many bought up highly leveraged speculative investments.
Sadly, yet predictably, the bottom fell out, which lead to runs on NYC banks and trust companies that had been financing these risky investments. Like the fall of the ocean waves, depositor confidence and stock market liquidly fell as many smaller banks drew down their deposits from the New York banks.
How Did JP Morgan Stop the Panic of 1907?
With no central bank to fall back on, leading financiers such as J.P. Morgan stepped up to the plate. By putting their own money on the line, they bailed out whatever was left of the banks and other financial institutions on Wall Street. Fundamentally, this earth-shattering event became the impetus for the establishment of the Federal Reserve System.
- The Panic of 1907 was a U.S. banking and financial crisis caused by failures in investment companies known as trusts which lead to bank runs.
- The Panic was caused by a build-up of speculative investments caused by relaxed monetary policies.
- Because there was no government central bank to fall back on, personal funds, guarantees, and heavy hitters including J.P. Morgan and John D. Rockefeller bailed out the U.S. financial markets.
- The Panic of 1907 was the incentive to fuel the need for heightened governmental oversight and public responsibility. All of this would give rise to the Federal Reserve System just a few short years later.
Understanding the Bank Panic of 1907
Over six weeks, beginning in October 1907, panic gripped the nation. Leading up to this fateful event, U.S. Treasury Secretary Leslie Shaw went on a shopping spree of sorts. And no, it wasn’t at Macy’s. Ms. Shaw had a taste for government bonds and engaged in large-scale purchases of such. Furthermore, she eliminated the need for banks to hold reserves against their government deposits. Thus, the foundation was laid, which fueled the largest supply of money and credit the country had ever seen.
Consider what this means? What do most people do with access to easy money? They speculate and speculate they did. This one action lead by Leslie Shaw was the fuel that would feed the fire during the widespread Panic of 1907.
What Lit The Match?
The bankruptcy of two small brokerage firms, F. Augustus Heinze and Charles Morse, lit the match that fueled the Panic of 1907. In an attempt to corner the copper market, Heinze and Morse speculated heavily trying to buy up shares in a copper mining firm.
Unfortunately, this resulted in a run on the banks that had backed them. Even as the banks stabilized, people were still panicked.
And if it couldn’t get any worse, this loss of confidence triggered a run on the trust companies. Without a doubt, the most prominent trust company to fall was New York City’s third-largest trust Knickerbocker.
If you weren’t already aware, Knickerbocker Trust was in dealings with Heinze and attempting to secure a loan. Unfortunately, banking magnate J.P. Morgan refused the loan.
With fear at an all-time high, Knickerbocker Trust saw a run for redemptions and could not withstand the withdrawal requests. Sadly, the third-largest trust failed at the end of October.
What Is a Redemption?
In the finance world, redemption means to repay any money market fixed-income security at or before its maturity date. As investors, we redeem money by selling part or all of our investments. This can be in the form of shares, bonds, or mutual funds.
With the fall of Knickerbocker Trust, public confidence in the finance industry shattered. To make matters even worse, panic eventually spread to the other financial powerhouses across America.
With coffers empty, the banks were desperate. So in an attempt to get ahead of looming bank failures, J.P Morgan, J.D Rockefeller and Treasury Secretary George Cortelyou provided millions in loans and deposits to the desperate banks and trusts.
In the days that passed, Morgan strongarmed NYC banks to give loans to brokerage firms for two main reasons. Firstly, to maintain stock market liquidity and secondly, to prevent the closure of the New York Stock Exchange. Later, Morgan organized the buyout of the Tennessee Coal, Iron and Railroad Company (TC&I) by U.S. Steel (owned by Morgan). The purpose of this was to bail out one of the largest brokerages that borrowed heavily, using TC&I stock as collateral.
What Were the Causes and Effects of the Panic of 1907?
The panic spurred the monetary reform movement that led to the establishment of the Federal Reserve System. Understandably, banking powerhouses like Morgan and Rockefeller were uncomfortable with the idea of having to continue to put their wealth on the line to stabilize the countries financial system as they should be quite frankly. S
o, as a result, they laid the framework for this responsibility to be the public.
Then came the Aldrich Plan. Named after sponsoring Senator Nelson Aldrich, the Aldrich Plan would form the Federal Reserve Act of 1913. And, of course, this would go on to create the Federal Reserve System.
With lofty goals of acting like the nation’s prudent central authority to control the nation’s supply of money and credit, its intent is commendable. It serves as a lender-of-last-resort to bailout over-leveraged, insolvent, and otherwise at-risk financial institutions.
The effects of the run caused a panic that reverberated throughout Wall Street, New York City banks and ultimately, many of the U.S. banking and manufacturing industries. What can we each learn from the Panic of 1907 and subsequent panics? I know that I don’t “speculate” or invest in anything I don’t understand. Wanton investing in fly-by-night stocks or crazes is a surefire way to lose all your hard-earned money. I take the time to do my research carefully and know my risks. And any of the money I do invest, I am willing to lose. That is why diversification in different asset classes is important. As the old saying goes, don’t put all your eggs in one basket.